Question

“The South African economy expanded an annualized 2.5 percent on
quarter in the three months to June of 2017, ending two quarters of
contraction and beating market expectations of a 2.1 percent rise. It is
the highest growth rate in the year, with agriculture, forestry, and fishing
making the largest upward contribution..”

Although this growth rate is low it has managed to break the technical
recession in South Africa.
Use the AD-AS model to illustrate the effect of such growth on the
general price level and the level of aggregate output in the South
African economy.

Answer 1

A higher level of productivity shifts the AS curve to the right, because with improved productivity, firms can produce a greater quantity of output at every price level.following Figure shows an outward shift in productivity over two time periods. The AS curve shifts out from SRAS0 to SRAS1 to SRAS2, reflecting the rise in potential GDP in this economy, and the equilibrium shifts from E0 to E1 to E2.

Panel (a): The rise in productivity causes the SRAS curve to shift to the right. The original equilibrium E0 is at the intersection of AD and SRAS0. When SRAS shifts right, then the new equilibrium E1 is at the intersection of AD and SRAS1, and then yet another equilibrium, E2, is at the intersection of AD and SRAS2. Shifts in SRAS to the right, lead to a greater level of output and to downward pressure on the price level. Panel (b): A higher price for inputs means that at any given price level for outputs, a lower quantity will be produced so aggregate supply will shift to the left from SRAS0 to AS1. The new equilibrium, E1, has a reduced quantity of output and a higher price level than the original equilibrium (E0).

A shift in the SRAS curve to the right will result in a greater real GDP and downward pressure on the price level, if aggregate demand remains unchanged. However, if this shift in SRAS results from gains in productivity growth, which are typically measured in terms of a few percentage points per year, the effect will be relatively small over a few months or even a couple of years.

How Changes in Input Prices Shift the AS Curve

Higher prices for inputs that are widely used across the entire economy can have a macroeconomic impact on aggregate supply. Examples of such widely used inputs include wages and energy products. Increases in the price of such inputs will cause the SRAS curve to shift to the left, which means that at each given price level for outputs, a higher price for inputs will discourage production because it will reduce the possibilities for earning profits. Figure (b) shows the aggregate supply curve shifting to the left, from SRAS0 to SRAS1, causing the equilibrium to move from E0 to E1.

The movement from the original equilibrium of E0 to the new equilibrium of E1 will bring a nasty set of effects: reduced GDP or recession, higher unemployment because the economy is now further away from potential GDP, and an inflationary higher price level as well.

Note:

• The aggregate demand/aggregate supply (AD/AS) diagram shows how AD and AS interact.
• The intersection of the AD and AS curves shows the equilibrium output and price level in the economy. Movements of either AS or AD will result in a different equilibrium output and price level.
• The aggregate supply curve will shift out to the right as productivity increases. It will shift back to the left as the price of key inputs rises, and will shift out to the right if the price of key inputs falls.
• If the AS curve shifts back to the left, the combination of lower output, higher unemployment, and higher inflation, called stagflation, occurs.
• If AS shifts out to the right, a combination of lower inflation, higher output, and lower unemployment is possible.